Commodities’ performance has been lackluster since 2006 (Figure 1). On table 1, we note that, even though the spot performance was very good, it was eaten up by the negative roll return. This is due to the steep contango of commodities’ forward curves from 2006 to 2012.

However, Figure 2 shows a revival of the commodities’ theme since the end of 2013, as commodities curves have exhibited a clear trend towards backwardation (defined by spot prices being more elevated than one-year-out forward prices). A series of climatic and geopolitical problems have indeed disrupted the supply of a significant number of commodities (impact of El Nino on soft commodities, potential consequences of the Ukrainian crisis on the production/transportation of wheat, natural gas, nickel…). In spite of this positive signal for the commodities indices’ roll return (Figure 2), the spot return performance remains depressed by the chronic lack of interest of index investors in this asset class (Figures 3 and 4).

Due to their low upside potential and the looming threat of regulatory backlash, commodity indices carry few promising long-term prospects for the investor. Therefore, we have developed a framework to replicate the performance of commodity indices by using a basket of commodities producers’ stocks and currencies (Table 2). The clone has a 60% correlation to commodities indices and its Sharpe ratio is markedly higher (Tables 4 and 5). Indeed, stocks and high-yield currencies do not have rolling costs and offer instead long-term risk premiums (dividends or carry returns). This commodities’ clone does not come without costs, though: its beta to equities is higher than the one of commodities (Table 5) and it correlates a bit less to CPI changes than commodities indices (Table 6), hence offering a less efficient hedge against inflation.

We may enhance the risk-adjusted performance of the clone by divesting away from the basket when its trend gets negative (see Figure 7). This increases the Sharpe Ratio by 20% and reduces the drawdown by half (Table 7).

Figure 1: Total returns of two main commodity indices since 2006

Table 1: Statistics (March 2000 – March 2014)

Figure 2: average one-year curve of commodities across a basket of 20 commodities (the curve is defined as the ratio of thirteen-months-out to prompt-month forward price -1) compared with roll return of DJ UBS over the next year (green, left scale)

About us

Disclaimer

The information herein is not intended to be an offer to buy or sell, or a solicitation of an offer to buy or sell any securities or financial instruments. This internet site is based upon sources believed to be reliable but is not guaranteed as to accuracy or completeness although Riskelia believes it to be clear, fair and not misleading. The view of Riskelia reflected in this site may change without notice. To the maximum extent possible at law, Riskelia does not accept liability whatsoever arising from the use of the material or information contained herein. These research documents are not intended for use by or targeted at retail customers. Should a retail customer obtain a copy of these reports he should not base his investment decisions solely on the basis of these documents but must seek independent financial advice.